ByGreg Michener, Guest bloggerJuly 28, 2011

Construction workers (top R) are seen on a site in Sao Paulo, Brazil July 5. Record low unemployment, competition for labor from a booming construction industry and inflation at a six-year high have put the squeeze on Brazil's small-and medium-sized businesses.

With the US teetering at the precipice of default, countries around the world are struggling to understand how they might be affected. Brazil’s current economic situation is a mixed batch: on the one hand, it is stable and flush with reserves (about US$350 billion); on the other hand, investors looking to diversify out of the dollar may be lured to the Brazilian markets because of the country’s high interest rates, putting further pressure on the much sought Brazilian real. While undoubtedly a downer for the manufacturing sector, a stronger real might bring about the conditions needed for long-awaited tax and labor reforms to occur.

A Strong real, the Dollar, and Inflation

The first semester of 2011 saw more than 30 billion real (about $19 billion) surge into Brazil, looking to cash in on some of the highest real interest rates in the world. This amount even compensated for Brazil’s trade deficit, which has gone strongly negative because of high domestic demands for imports, driven by the surging Brazilian real.

Investors have forced up the real’s value, but so too have continuous demands for Brazil’s commodities (driven mainly by China) — the currency has appreciated by more than 35 percent since 2005. Ironically, the government’s principal means of combating inflation — now running at 6.5 percent — is to raise interest rates, which further increases the flow of investment money into Brazil, putting upward pressure on the real.

Interestingly, just as the international markets appear to be dumping dollars, many Brazilians have been doing just the opposite. My mother-in-law had to order dollars a week in advance; the strong real and uncertainty about inflation is prompting many Brazilians — ironically — to buy dollars.

Manufacturing Sector Ekes out a Margin while Government Gets Fatter

As a result of the strong real, Brazil’s manufacturing sector is getting hit hard on exports. The commercial deficit, which excludes construction, public utilities, and commodities, was R$30.4 billion in 2010, reports Estado de São Paulo. Luckily, the internal market is strong and high-tariff walls still serve to protect Brazilian industry from foreign competitors.

Yet just as the manufacturing and industrial sectors are feeling something of a squeeze, the government is posting record revenues on taxes. The Estado de São Paulo reported that government accounts are up 123 percent over the same period last year. Remember, of course, that last year was an election year, and President Luiz Inácio Lula da Silva was spending prodigiously to ensure his anointed successor’s victory. Last year the government went into the red, making this year’s surplus — relative to the same period last year — more comprehensible and, indeed, less impressive.

But revenues appear to be up also because of record tax receipts — almost 20 percent more than last year’s first semester, according to the same Estado de São Paulo report cited earlier. The windfall in tax dollars may be a result of the increased consumption of imports, whose tariffs pay out handsomely for government, and from higher income tax revenues, the product of an increase in real wages — a higher minimum wage and wage inflation.

Current financial windfalls put the government in a strong position to spend more money. After having paid off most of President Lula da Silva’s pre-election debts, President Dilma Rousseff is apparently eager to do just that — plough dollars into infrastructure and social programs.

The interesting thing about the simultaneous increase in taxes and the value of the real is that it has put greater pressures on business, particularly the manufacturing and industrial sectors, both of which have become less competitive both here and abroad.

Business, in turn, is understandably putting greater pressure on government for reform. Several organizations have launched campaigns for reforms, as exemplified by this tax-protest video by Brazil’s Federal Confederation of Industry. Taxes and bureaucratic procedures that used to be taken for granted are now being examined with a more critical eye by business, a sector keen to exploit efficiencies. Corruption and waste have also come under the microscope, phenomena that make a high tax burden and rigid bureaucratic imperatives all the more bitter to swallow.

Business owners regularly complain that if they were to comply with all tax and labor laws (which impose their own taxes), they would not be able to keep their businesses afloat. As it stands, the system encourages evasion, illegality, and informality. Tax reform has become a big issue, and President Rousseff has promised to send a tax reform to Congress one piece at a time. The odds are not good: former presidents Fernando Henrique Cardoso and Lula da Silva both failed. What is sure is that the government needs to update burdensome, anachronistic policies that continue to jeopardize Brazil’s international competitiveness.

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